February

Lawyers Journal

Law school bubble: How long will it last if grads can't pay bills?

By William D. Henderson and Rachel M. Zahorsky

February 2012

Reprinted with the permision of the ABA Journal.

For Andrea, a past decision to ensure her future in law has left
her in a stressed and distressful present. Concerned over how it
might affect her job prospects, she would not allow use of her real
name. And there is reason for concern: She's been laid off twice
since her 2009 law school graduation, including from a position
where she earned $20 an hour at a small firm practicing as a
licensed attorney. For the 29-year-old, who's supported herself
since college, the financial repercussions of law school may amount
to the worst investment of her life, despite a degree from a
second-tier school and a resumé that boasts a position on law
review and coveted summer associate positions.

"I deferred my loans because of economic hardship the first time,"
says Andrea, who borrowed nearly $110,000 to finance her education.
"After that," she falters, "they might be in forbearance … accruing
interest … I just don't know."

Andrea's situation is far from unique. In 2010, 85 percent of law
graduates from ABA-accredited schools boasted an average debt load
of $98,500, according to data collected from law schools by
U.S. News & World Report. At 29 schools, that amount
exceeded $120,000. In contrast, only 68 percent of those grads
reported employment in positions that require a JD nine months
after commencement. Less than 51 percent found employment in
private law firms.

The influx of so many law school graduates - 44,258 in 2010 alone,
according to the ABA - into a declining job market creates serious
repercussions that will reverberate for decades to come.

Moreover, lawyer salaries vary greatly across the country, with
the top 35 legal markets sucking up 75 percent of the payroll (see
"What America's Lawyers Earn," ABA Journal, March 2011).
And the number of law office jobs in private practice peaked at
1.23 million in 2004 ("Paradigm Shift," July 2011).

Heavy loans now threaten to consume the future earnings and
livelihood of the nation's young lawyers. Yet, even as the legal
market contracts, more than 87,900 potential candidates vied for
60,000 seats at 200 ABA-approved law schools in 2011, according to
the Law School Admission Council.

More than 78,900 have applied for 2012 spots, according to
preliminary LSAC counts in November.

Youthful overoptimism, bleak job prospects for college grads and
the entry of several more universities and for-profit businesses
into the legal education business are some of the root causes for
the supply-and-demand imbalance in entry-level lawyers.

Very few critics, however, have examined the part played by the
federal government through its student loan policies in creating a
law school bubble that may be on the verge of bursting - one
strikingly similar to the mortgage crisis that cratered the economy
in 2008.

Direct federal loans have become the lifeblood of graduate
education, and they shelter law schools financially from the
structural changes affecting the profession. The bills are now
coming due for many young lawyers, and their inability to pay will
likely bring the scrutiny of lawmakers already moaning about
government spending.
BUCKS BACK BOOKS

As student groups continue to lobby the federal government for
increased transparency, the lawmakers are bound to ask a very
simple question: Why should the U.S. government, through the
Department of Education direct-lending program, continue to make
billions of dollars of loans to law students when structural
changes in the legal market suggest that a large portion will lack
the earning power to repay those loans?

The answer to this question has potentially grave implications for
legal education. Law schools - many for the first time ever - will
become vulnerable to significant cuts in the amount of money
available to students as Congress tries to hold the line on
additional deficit spending.

"There were people warning about this 10 years ago, but a lot of
people were not paying attention to it," says Phoebe A.

Haddon, dean of the University of Maryland School of Law. "But debt
wasn't as great as it is now, and the likelihood that people could
repay tuition was built on a different financial structure of law
firms."

Haddon adds, "I've seen a 20 percent increase in the amount of
debt that our students have experienced in the last several years,
and it's mind-boggling to me how that can continue without a better
response of how to support legal education in the future."

Since the GI Bill, America has operated on the principle that
higher education always delivers a return on investment. As such,
Congress created a host of programs during the Great Society era of
the 1960s to expand access to colleges and universities.

Law students, along with medical and dental students, are treated
generously as future professionals and able to borrow, with
virtually no cap, significantly more money than undergrads.
America's law students borrowed at least $3.7 billion in 2010 to
pay for their legal educations. Although the majority of the funds
came from the Education Department, the patchwork of mechanisms
that serve higher education as a whole make it difficult to
regulate how much is being lent and to whom.

For several decades, most higher education loans were made by
private lenders with the federal government providing guarantees
against loss - and, in some cases, interest rate subsidies. Any
remaining student expenses were met by private lenders without the
benefit of federal guarantees.

When U.S. credit markets seized in 2008, there was worry that
there would be insufficient federal or private loan funds to meet
the financing needs of all students enrolled in U.S. colleges and
?universities. So the Education Department, under the authority of
a new federal law passed in the spring of 2008, began buying up the
federally guaranteed loans, making them direct loans from the U.S.
government.

In 2010 Congress passed the Student Aid and Fiscal Responsibility
Act, part of President Barack Obama's final health care overhaul,
which ended federally guaranteed student loans and replaced them
with direct loans made through the Education Department. In effect,
by converting the loan guarantees into an income-producing asset,
the federal budget was reduced by $61 billion over 10 years.

Some of that savings was earmarked for additional educational
grants and funding for community colleges. But some was allocated
to help fund the national health care plan, hence its inclusion as
part of the health care bill.

In the short term, the student loan overhaul may have been
brilliant political maneuvering. But in the longer term, if a large
portion of students don't repay their full loans, the perceived
benefits of interest income on direct federal student loans will
become an enormous financial liability. And there are good reasons
to believe this might happen.

THE GOVERNMENTAL GAMBLE

The Education Department does not make lending decisions based on
credit scores, at least for Stafford loans, the primary funding
mechanism for both undergraduate and professional schools. Nor does
it conduct a rigorous analysis on how graduation from particular
institutions affects an individual's income or earning power. The
protections for the U.S. Treasury are largely on the back end:
Changes to the federal bankruptcy code over the last 15 years have
made it extremely difficult to discharge student debt.

But sheltering loans from bankruptcy does not guarantee that the
government will receive steady repayment, as several layers of loss
apply.

Though the latest loan default rates are far below the 22.4
percent peak in 1990, according to Education Department figures,
they have been rising since 2003. While direct-lending program
budget projections seem to preclude any possibility of loss, future
budgets based on historical default rates can be upended as the
legal market constricts. The default rates could be higher than the
historical average as anticipated gains in earning power fail to
materialize and lost jobs do not come back.
Likewise, the Congressional Budget Office may have underestimated
the extent to which students will be eligible for the federal
Income-Based Repayment plan, a relatively new innovation. IBR caps
student loan repayment at 15 percent of adjusted gross income.
Extensive use of that plan would both reduce revenues and create a
shortfall in program funding for new loans. With approximately $200
billion in student loans each year, and high amounts projected in
years to come, a 10 percent shortfall in repayments under IBR could
amount to $20 billion to $30 billion lost.

By failing to make rigorous, realistic actuarial assumptions in
deciding who to lend money to and how much to lend, the federal
government avoids politically uncomfortable trade-offs. Everyone
can go to college. And if you can get accepted into law school, the
government will finance that, too.

But as the economist Herbert Stein once said, "If something cannot
go on forever, it won't." The federal government's gamble that
higher education will continue to result in higher personal incomes
eerily echoes Wall Street's risky assumption that historical
patterns in real estate values would carry forward forever and
enable many sliced-and-diced mortgage-backed securities to attain
AAA ratings.

While it may be politic, even patriotic, to assume that the
higher-education-equals-higher-income equation is fact, for
investors it remains, at best, aspirational. Since 2008, private
investment in nearly any market has been reluctant. The capitalists
aren't taking this education-equals-high income bet; if they did,
the terms they would demand would likely change the choices that
student borrowers are now making.

Unless the government's actuarial assumptions on student loan
repayments turn out to be correct, federal funding of higher
education is on a collision course with the federal deficit.

Optimistic assumptions of future growth and earning power,
however, are completely at odds with the financial landscape that
has given rise to the so-called scamblogger movement and some
recent lawsuits by graduates alleging their schools committed fraud
and other deceptive practices regarding portrayals of job
prospects.

COUNTING THE DISCOUNTS

The cost of legal education is more complicated than tuition,
books and living expenses. Although published tuition is usually
very high (Harvard's 2010-11 rate was $47,600), more than half of
all enrolled students receive some sort of discount.

The vast majority of these discounts come in the form of
merit-based scholarships based on undergraduate grades and LSAT
scores. Merit scholarships are not guaranteed over the three years
of schooling. Recent news media coverage has noted that
scholarships based on beating the law-class grade curve can leave
many students without scholarships and several semesters left to
complete degrees, often paid for by more federal loans.

And while some scholarships are financed through law school
endowments, most are cross-subsidies by incoming students: Student
A pays full tuition - largely financed through loans - so that
student B can receive a discount.

The cross-subsidy is fueled by competition among schools to
maximize prestige as measured by U.S. News rankings. The
credentials of entering classes represent a significant component
of the ranking formula - a combined 22.5 percent, as described by
U.S. News.

Because of this system of variable tuition, some students graduate
with little or no debt. A much larger group graduates with
considerable debt.

For law students who have not defaulted on prior federal student
loans, the first $20,500 per year in loan funding is typically a
federal Stafford loan at an annual interest rate of 6.8 percent.
Because the yearly cost of law school attendance often far exceeds
$20,500, a large proportion of students take out federal Direct
PLUS loans, which carry a 7.9 percent yearly interest rate plus a 4
percent one-time charge at the time of disbursal. The only limit
imposed is the cost of attendance minus any other financial
assistance.

Students who choose the highest-ranked school to accept them tend
to be the biggest borrowers because their LSAT scores and
undergraduate GPAs are more likely to be below the school's median
statistics. As a result, these students get less merit scholarship
aid, which pushes their cost of attendance to $40,000-$65,000 per
year. After three years, the cumulative debt is $120,000-$195,000,
with a blended interest rate of roughly 7.3 percent.

Assuming a total debt of $150,000 (the amount currently carried by
several thousand law graduates), the total monthly payment is
$1,743.46 a month for 10 years, according to the Education
Department's repayment calculator. For law graduates who opt for
the 25-year graduated payment plan, which starts at about $930 a
month and increases over time, that amortizes to $357,229, more
than double the original amount.

According to NALP, the association for legal career professionals,
the median starting salary for a lawyer who graduated from law
school in 2010 is $63,000. For a recent, unmarried law school
graduate making $63,000 and getting single-digit-percent annual pay
increases, the chasm between income and prospective repayment is
impractical for both the student and the government.

This combination of high debt and moderate income makes this
all-too-typical law graduate eligible for the federal government's
income-based repayment program. According to FinAid's IBR
calculator, used by many law school financial aid counselors, the
student will make monthly payments of $584 the first year and
$1,605 in year 25. After 25 years, the loan is forgiven. At that
time, more than half of the principal, $76,000, will not have been
repaid, along with $26,000 in capitalized interest.

The government write-down for this student is about $103,000,
which may be offset by an eventual tax payment: Under the current
Internal Revenue Code, the law school grad would have $103,000 in
imputed income for the debt forgiveness. Of course, the government
would have to collect it from someone near enough to retirement to
be eligible for membership in AARP.

Surveying the current landscape for law jobs, income-based
repayment is surely the fate that awaits many current and future
law school grads. And their unpaid loan balances reduce the federal
funds available for future student loans.

ENDGAME

Given the likelihood of some form of curb in federal student
lending, there are gut-wrenching times ahead for law schools - even
those that continue to enjoy a surplus of applicants. Until we get
to that point, however, the lawyer production machine will continue
to churn out more lawyers.

For those trying to get through this fiscal year, a government
write-down of student debt may seem far away and speculative.
Within a few years, however, the government will gain more
experience on the IBR program, permitting a more accurate
calculation of what its loan assets are really worth.

All the while, the stakes are growing larger. The volume of direct
loans to students is estimated to increase from $489 billion in
2009 to $1.8 trillion in 2020, according to the Office of
Management and Budget. Between 2 and 4 percent - $36 billion to $72
billion - will be for law school graduates.

Besides rising defaults and heavy use of income-based repayment,
federal student lending is vulnerable to other attacks. Although
IBR may be viewed as a boon to law students, law school graduates
may view it differently - 15 percent of their monthly income paid
over more than half of their career span is a severe burden,
especially if the sought-after gains in earning power fail to
materialize.

For federal education loans, law students are grouped together
with doctors and dentists, even as the U.S. Bureau of Labor
Statistics acknowledges a shortage of those professionals and a
growing glut of lawyers. Further, the bureau projects that these
shortages and surpluses will continue over the next decade.

Does the right hand of government know what the left hand is
doing? If too many law school graduates are forced to invoke IBR,
the Education Department will eventually have to justify writing
checks to law schools.

Mark Grunewald, interim dean of the law school at Washington and
Lee University, thinks any blanket restrictions on federal student
lending would be disastrous and unfair. "There are real differences
among prospective law students' economic circumstances, and new
blanket restrictions on lending could hurt those most in need of
financial support," he says. "It's also unclear what the legal
employment market might look like after a general economic
recovery. Market forces may ultimately prove to be a better
corrective."

Still, scrutiny by the scamblogger movement and legal and
mainstream media may speed up the process. One plausible outcome
has the Education Department using its accreditation authority to
force law schools to demonstrate, as a condition of receiving
federal loan money, a minimum threshold of employability and income
upon graduation.

As today's prospective law students survey their options, they see
few career paths that are affordable and intellectually
challenging, and that offer secure economic returns and the
potential to be socially meaningful. Based on the other
alternatives, many still argue that a law degree is as good a bet
as any. This may be true. But the more vexing question is why a
gambling metaphor now seems so apt for legal education.

Six figures of debt, a heavy interest burden and poor job
prospects - this is no way to begin a legal career. Some graduates
will no doubt hang their own shingles and build successful
practices, but many others will start practicing law without proper
capital or mentorship. This is dangerous territory for the
profession. Dating back to the 1950s, research on lawyers has shown
a strong link between lawyer misconduct and the economic stress of
too many lawyers chasing too little, unsophisticated legal
work.

The easy credit that feeds legal education will eventually exact
costs that go beyond recent law school graduates. Andrea is one who
knows that personally.

"The face of the law profession has changed. Even the ones who
don't have jobs think it will bounce back and be the same, but it
won't. This is a totally different game.

"The last few years were the hardest of my life. I've essentially
lost my dream. … It's like I've failed at everything. If I'd known
what would happen, I would have gone another way. I would have
stayed at my firm, became a paralegal. I wouldn't have taken on
this debt. I don't have anything or anyone else to fall back
on."

The U.S. legal profession is in the midst of a broad structural
transformation. Meeting the challenge to compete in a global
economy requires a higher-education policy that honestly addresses
issues of access, cost containment and national interest.

Legal education may soon provide an object lesson of what happens
when we do nothing: Bad things happen when lawyers and law
professors stick their heads in the sand. The republic may be in
need of some world-class lawyerly judgment. And maybe soon.